How to Report 1031 Exchange on Tax Return

A 1031 exchange allows taxpayers to defer capital gains taxes when they exchange real property held for productive use in a trade or business or for investment for like-kind property. Proper reporting on your federal income tax return is essential to maintain its tax-deferred status.

Gathering Information for Form 8824

Form 8824, “Like-Kind Exchanges,” is the primary Internal Revenue Service (IRS) document used to report a completed 1031 exchange. Taxpayers can obtain this form and its accompanying instructions directly from the official IRS website. Before completing Form 8824, taxpayers must gather specific information and supporting documentation related to both the relinquished and replacement properties.

Gather detailed descriptions of both the relinquished (old) and replacement (new) properties, including their full addresses and the specific type of property involved, such as real estate or certain personal property. The exact dates of the exchange are also required, specifically the date the relinquished property was transferred and the date the replacement property was received. These dates are typically found on the closing statements for each transaction.

The fair market value (FMV) of both the relinquished and replacement properties at the time of the exchange must be determined. This value is generally established through appraisal reports or the agreed-upon sales prices documented in the closing statements. Determining the adjusted basis of the relinquished property is also a crucial step. This figure represents the original cost of the property, plus any capital improvements made over its ownership period, reduced by any depreciation previously claimed. Prior tax returns and property records are primary sources for this data.

Any liabilities, such as mortgages or other debts, attached to both the relinquished and replacement properties must be documented. It is important to note how these liabilities were treated within the exchange, whether they were assumed by the other party or relieved from the taxpayer. Closing statements will detail these financial arrangements, showing amounts paid off or taken on. This information is necessary for calculating any recognized gain due to mortgage relief.

“Boot” refers to any non-like-kind property received in an exchange, such as cash, property not of like-kind, or debt relief. Taxpayers must identify and quantify any boot received or given during the exchange. For example, if a taxpayer receives cash back at closing, that amount constitutes boot received. All exchange expenses incurred, such as qualified intermediary fees, legal fees, appraisal costs, or title insurance, also need to be collected. These expenses may affect the calculation of gain or the basis of the new property and are often found on the closing statements provided by the settlement agent.

Completing Form 8824 and Related Schedules

After gathering all necessary financial and property details, complete Form 8824. This involves systematically entering the collected information into the designated sections of the form.

The form then guides the taxpayer through calculating the realized gain or loss from the exchange. This calculation considers the adjusted basis of the relinquished property, the fair market value of the property received, and any boot received or given. For instance, the realized gain is generally determined by subtracting the adjusted basis of the relinquished property from the sum of the fair market value of the like-kind property received, any boot received, and any liabilities assumed by the other party.

Reporting boot received is a critical component, as it can trigger recognized gain, even in an otherwise tax-deferred exchange. If cash boot is received, that amount is generally recognized as gain, but not more than the total realized gain. Similarly, if liabilities on the relinquished property exceed those assumed on the replacement property, the amount of debt relief constitutes boot received, which can also lead to recognized gain. Form 8824 provides specific lines to calculate this recognized gain, distinguishing between cash and mortgage relief.

Information from Form 8824 often flows to other relevant tax forms, particularly Schedule D, “Capital Gains and Losses,” and Form 4797, “Sales of Business Property.” Any recognized gain from the exchange, such as that resulting from boot received, is typically reported on Schedule D if the property was held for investment. For example, if a taxpayer receives cash boot, the recognized gain from that cash is carried from Form 8824 to Schedule D, where it is reported as a capital gain.

Alternatively, if the relinquished property was depreciable property used in a trade or business, any recognized gain, particularly that attributable to depreciation recapture, is reported on Form 4797. For instance, if the recognized gain includes an amount that would have been ordinary income due to prior depreciation deductions under Section 1245 or Section 1250, that portion is reported on Form 4797. The remaining recognized gain, if any, is then typically transferred to Schedule D.

For most 1031 exchanges, the primary linkage is to Schedule D and Form 4797. Once Form 8824 and any related schedules are completed, they must be attached to the taxpayer’s federal income tax return, typically Form 1040, before submission to the IRS.

Basis Adjustments and Depreciation

After a 1031 exchange is completed and reported, the tax implications extend to the replacement property, particularly concerning its adjusted basis and future depreciation. The replacement property does not receive a new basis equal to its fair market value. Instead, it generally takes on a “substituted basis” or “carryover basis” from the relinquished property. This means the unrecognized gain from the exchange effectively reduces the new property’s basis, preserving the deferred tax liability.

The calculation for the adjusted basis of the replacement property involves specific adjustments. It begins with the adjusted basis of the relinquished property, adding any additional cash paid by the taxpayer to acquire the new property, and increasing it by any liabilities assumed on the replacement property. This amount is then reduced by any boot received by the taxpayer in the exchange, and also reduced by any liabilities relieved from the relinquished property. This formula ensures that the deferred gain is embedded in the new property’s basis.

Depreciation of the replacement property after a 1031 exchange is handled in a unique manner due to the substituted basis. The portion of the replacement property’s basis that is attributable to the deferred gain from the relinquished property generally continues to be depreciated over the remaining depreciation schedule of the old property. This is often referred to as “split depreciation” or “component depreciation.” For example, if the relinquished property had 10 years remaining on its depreciation schedule, that portion of the replacement property’s basis will continue to depreciate over those 10 years.

Any additional basis in the replacement property that comes from new money invested or new liabilities assumed by the taxpayer is depreciated separately. This “new” portion of the basis typically begins a new depreciation schedule, generally over 27.5 years for residential rental property or 39 years for nonresidential real property, starting from the date the replacement property is placed in service.